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In Target-Date Funds, a Hodgepodge of Styles

CHOOSING among the often-confusing lineup of mutual funds offered in 401(k)retirement accounts can be an unwelcome chore. Increasingly, employees have been embracing a simpler choice: all-in-one mutual funds known as target-date retirement funds, or T.D.F.’s.

Assets in these funds have more than quadrupled since 2007. For employees, the funds appear very straightforward, requiring only the choice of an expected retirement date. Once a fund with an appropriate target date is chosen, investment professionals take charge. They decide on a mix of assets that gradually becomes more conservative as the employee nears retirement.

“Workers are delegating back to their employer the asset-allocation decision,” says Stephen P. Utkus, principal of the Vanguard Center for Retirement Research. Put another way, workers are delegating to their employer, who is then delegating to the plan provider it has hired, to run a target-date fund within a 401(k). The T.D.F is typically comprised of a mix of mutual funds run by the plan provider.

There is a very wide range of T.D.F.’s, and that may be a problem because they have a whiff of the old Wild West about them: just about anything goes. For example, Morningstar found that among three dozen funds with a target retirement date of 2025, the percentage of fund assets invested in stocks ranged from 38 to 86 percent, with an average of 70 percent. The retirement investment industry and Washington regulators have basically left it to investors to figure out what their T.D.F.’s contain, and to decide if their plan dovetails with their risk and return expectations.

But what T.D.F.’s do quite well is distance investors from their worst enemy: themselves. By hewing to a long-term investment allocation strategy and rebalancing whenever the markets throw the portfolio off that strategy, they insulate investors from many emotional and psychological barriers that can make it hard to stick with a given approach.

“It’s akin to a stereo system,” said Meir Statman, professor of finance at Santa Clara University in California and author of “What Investors Really Want.” “Rather than having to purchase all the individual components and figure out how to make it work together, a T.D.F. is like buying a single, integrated system. Maybe you give up some flexibility, but that’s still a good trade-off for many investors.”

That idea offers some comfort to many investors. A recent ING survey of 401(k) investors found that those who used a T.D.F. were more confident about their retirement prospects than investors who didn’t own such a fund.

Assets in target-date funds grew to $374 billion at the end of 2011 from $71 billion four years ago. The Employee Benefit Research Institute, a nonpartisan group that specializes in economic security issues, says that nearly half of workers hired in 2009 and 2010 who were enrolled in a 401(k) owned a T.D.F.; in 2006, just 28 percent of new hires did. Vanguard, a big manager of target-date funds, says it anticipates that 75 percent of employees enrolled in its plans will own such a fund by 2016.

The growing popularity has been aided by a big nudge from Washington. In 2006, the Labor Department allowed employers to automatically enroll employees in 401(k)’s, and when employees did not actively choose among the funds offered in a plan, employers could also automatically put them into a T.D.F. that matched their expected retirement age.

But automated simplicity isn’t a magic bullet. “The potential problem is that the T.D.F. you are given isn’t really that good,” Professor Statman says.

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Byron Eggenschwiler

For example, a recent survey by Callan Associates, an investment consulting firm, found that 63 percent of such funds used actively managed funds and that an additional 17 percent used a mix of active and index-based funds. Historically, active management has been less effective than passive index-based investing.

On an asset-weighed basis, the average annual expense ratio charged on target-date funds is 0.61 percent, according to Morningstar. Vanguard, which has an average charge of 0.18 percent for its T.D.F.’s, is the only major manager that emphasizes index-based funds for them. Target-date funds that are actively managed tend to have annual expense charges above 0.70 percent — though many exchange-traded funds charge less than 0.30 percent.

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Both TIAA-CREF and Fidelity have started low-cost, index-fund-based T.D.F.’s in the last few years, but assets in them are dwarfed by each provider’s more expensive actively managed funds.

A vast majority of 401(k)’s offer only funds run by the plan provider. For the providers, keeping all assets in-house makes plenty of business sense. But for plan sponsors, who have a fiduciary responsibility to run the plan for the benefit of employees, being able to pick and choose among different managers would offer the chance to package a T.D.F. made up of best-in-class funds. ING reports that only 6 of the 21 largest target-date funds now use nonproprietary funds.

THEN there is the debate over glide paths — the strategy that each fund uses to gradually shift assets for a given target date to a more conservative bent as retirement nears. There is no industry standard, and these paths vary widely.

Lori Lucas, the leader of Callan’s defined-contribution practice, says arguing over the right one path misses the point. “You can make a case for a variety of different glide paths,” she said. “The issue is whether the glide path a sponsor has chosen makes sense for its employees, and whether employees are getting enough information on how their glide path works.”

A study conducted by Ibbotson, a Morningstar subsidiary, says that many T.D.F. glide paths have been evolving. For example, Ibbotson said that in 2002, the particular Fidelity Freedom fund intended for a 60-year-old worker had a 34 percent equity allocation. In 2006, a 60-year-old in the age-appropriate Fidelity Freedom fund had a 53 percent equity allocation. More recently, Ibbotson said, the glide-path allocations of Fidelity T.D.F.’s have bounced around much more than those of T. Rowe Price or Vanguard. The three fund companies manage three out of every four dollars invested in T.D.F.’s.

Christopher Sharpe, a co-manager of Fidelity’s T.D.F.’s, says the company made a strategic decision in 2006 to wait longer to roll down the equity stake for investors of particular ages. “That change manifested itself over the next five years for investors,” Mr. Sharpe said. He also said Fidelity had been adding alternative assets in recent years, including commodities, real estate investment trusts and floating-rate debt, that could change how Ibbotson calculated glide-path stability. He stressed that those changes were “aiming for the same return with a smoother ride.”

Vanguard also made a shift in 2006 to maintain higher equity stakes for investors at given ages, but it has not added alternative asset classes. In 2010, T. Rowe Price began incorporating its Real Assets Fund, which holds real estate investment trusts and commodities, into its T.D.F.’s.

“Now that there’s so much more money in T.D.F.’s, firms are taking a harder look at what their process is,” says Mr. Idzorek, a co-author of the Ibbotson study. “I would suspect some level of instability as firms figure this out.”

In the meantime, more managers are practicing selective tweaking. According to a Callan survey, 24 percent of T.D.F. managers in 2009 said they incorporated a tactical overlay — shorter-term shifts in response to market conditions — to their long-term strategic allocation goals. By 2011, that figure had grown to 37 percent.

Ms. Lucas of Callan says T.D.F. managers who struggled with frequent rebalancing during the depths of the financial crisis were looking for more leeway during extreme market volatility. But that is typically a tweak, not a wholesale shift. For example, T. Rowe Price says it reserves the right to let its glide-path allocations stray up to 5 percentage points from its stated allocation target. “T.D.F.’s exercise judgment,” Ms. Lucas says. “It’s up to the participants to figure out if they are comfortable with that strategy.”

A version of this article appears in print on April 8, 2012, on Page BU12 of the New York edition with the headline: In Target-Date Funds, A Hodgepodge of Styles. Order Reprints|Today's Paper|Subscribe